Business valuation: From misperception to understanding

by Bart Basi

Most people realize the need to know the value of their personal property, such as a house or automobile, in order to get top dollar for the sale of these items. If a seller does not know the value of the item being sold, any buyer has the potential to swindle the seller out of their auto or house. In some cases, thousands of dollars are lost to the seller in such transactions.

The same is true for business owners. Many business people are not familiar with a business valuation, why they need one, and how to get a valuation done. In fact, many business people are more familiar with the value of their house or automobile than the value of their business, which surprisingly, may be worth more or carry more equity than their house! In the business world, not knowing the value of a business can translate into the loss of a lifetime of work in value and dollars.

What is a valuation?
There are many misperceptions about valuations. Many business owners believe a successful valuation can be calculated based on simple multiples. For instance, someone is always inquiring as to whether he or she can multiply the gross income or net profit by 3, 4, 5, 6, or 7 based upon some theoretical condition of the business to reach a value conclusion. Neither the IRS nor a potential buyer will accept these multiples as a sound valuation. Four decades of experience in this profession and a whole host of IRS letter rulings, memorandums, statutes, and cases demand that a simple multiple in determining value CAN NOT BE USED to arrive at a valid figure. Business valuations are much more sophisticated than what a multiple can determine.

A business valuation is a report written by a qualified appraiser for purposes including business succession, estate and tax planning, litigation, buy-sell situations and other purposes. A business valuation will reflect the value of a business that a willing buyer would agree to pay in an arm’s length transaction. Revenue Ruling 59-60 reflects much of the methodology used in a valuation. The value of a business tends to be different from the actual selling cost of the business in 99 cases out of 100 for the same reason services such as Kelley Blue Book reflect theoretical value instead of an ironclad guarantee on a trade-in or sale of a car. The value of the business is simply a number arrived at for the purpose of a starting point to negotiate the sale, exchange or transfer of a business.

The value of a business is a moving target. It is critical that the valuation be done each year to update the net worth of the owner. A proper business valuation is much more valuable than the annual balance sheet of a company.

The appraiser
By definition, the valuation should be in the form of a written report. Oral reports from a valuator simply will not suffice because buyers, sellers and the IRS will not see much credibility in an oral report. It is also impossible to remember every important detail of a thorough report. That is why a written report is highly recommended.

Further, the valuation must be done by a qualified appraiser. First, the appraiser must be someone who does not have a bias concerning the value of the company. Generally, friends, relatives and employees are excluded automatically from the definition. Also, the company accountant should not conduct the valuation since he or she is not in a position to be objective. Next, the appraiser must be an expert on the matter. Being a CPA or attorney is simply not enough to certify a person as a qualified appraiser. The appraiser, by definition, must have the experience and training in both the areas of valuation and in the industry in question. The IRS and the courts will disqualify individuals who try to value companies when the business appraiser does not really know or understand the industry. Remember, always select an appraiser who knows the industry the business is in.

Business succession
Business succession is a process of transferring a business to an individual, group of individuals, or an entity for an exchange of money. However, in many cases, it involves transferring the business to a family member. Typically, a family member will be interested in taking the business over at some point in time. A proper business valuation must take into account the objectives to be accomplished.

Before any business succession planning takes place, a value must be determined for the business. Subsequently, any course of action will be determined based on the value of the company. Usually, business owners are surprised at the value of their businesses and will determine what course of action to take once the valuation is completed. For example: If a business value turns out to be very high, the owner may want to forego plans of transferring the business to a family member and may want to sell it to a third party. Alternatively, if the value is lower than expected, as in the case with a debt ridden business, the buyer may decide to simply transfer the business to the first taker for the amount of the debt and start anew or retire. Determining value should be one of the first steps in any business succession plan, no matter whether the owner plans on selling to a third party, gifting to a family member, or selling to employees.

While business succession planning and determining value for that purpose is largely optional, the estate tax (also known as the death tax) is not optional. The estate tax is a tax on the RIGHT to transfer property from one individual to another at death. No matter whether a business owner decides to transfer the business or makes a plan during life, the IRS mandates that a value will have to be determined at death for estate tax purposes. It is much easier to start an annual valuation program while you are in control rather than having a value forced on you when you die.

However, having your company valued during your life is much more useful than having it done post life. Having a business valuation done during your life will accomplish the plan for estate tax savings as well as business succession. Knowing the estate tax potential now will allow the business owner to engage in planning for taxes and business succession as well.

A business valuation establishes an annual value and allows the business owner to see his or her tax situation; it also alerts the owner to the necessity for succession planning. Businesses face dismal odds when a successful business succession plan is not written. It is therefore important to have a valuation done for business succession as well as estate tax purposes now.

Conclusion
Business appraisal is an aspect of business that is to be taken extremely seriously. It is important not only for the reasons discussed, but also for peace of mind. Having a qualified business appraiser value your business is of utmost importance. Making the mistake of choosing an inexperienced or incompetent appraiser can wind up costing you more than the money you will save in choosing economy over quality.

Bart Basi is president of The Center for Financial, Legal and Tax Planning Inc. He will lead a presentation on “Valuing Business” during the Tech & Consultants’ Fair at the STAFDA convention in Las Vegas on Nov. 13.

The Center specializes in business valuations and would be happy to assist you with your valuation needs. Bart and his experienced and competent staff have been working with STAFDA members ever since STAFDA was formed. They are extremely knowledgeable about the industry and are respected by both the courts as well as the IRS when it comes to valuing STAFDA businesses.

This article appeared in the October 2006 STAFDA issue of Progressive Distributor. Copyright 2006.

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